What Is A CFD?

pen chart A CFD, or a Contract for Difference is a leveraged derivative product. Formally, it is an agreement between two parties to exchange the difference between the opening price and closing price of a contract. A CFD allows one to go both long (buy) and short (sell).  It is worth noting that the CFD market is not regulated by Monetary Authority of Singapore.

One reader recently asked us if a CFD has any “meaningful role to play in value investing”.

According to Philip, there are 444 locally-listed companies that offer CFD trading. Some of them include Breadtalk Group Limited (SGX: 5DA), Golden Agri-Resources Limited (SGX: E5H) and Keppel Land Limited (SGX: K17).

Differences Between CFDs and Investing

CFD comes under the umbrella of trading rather than investing. Trading is more short-term oriented. Traders focus more on the price and mostly use technical analysis to base their decisions. Some traders, also known as scalpers, can even hold a position for mere seconds.  Value investing mainly involves investing in shares at a price lesser than its intrinsic value and tends to be more long-term oriented. Investors rely on fundamental analysis of a business by looking into the qualitative and quantitative aspects.

Emotional Roller Coaster

Choosing to buy CFDs of companies in the view of holding it for the long-term may be risky. CFDs are leveraged products and when the market takes a turn, we may face margin calls where the broker asks the trader to top up more money to maintain his position. This may become emotionally draining, causing the trader to close his position prematurely. Also, busy individuals would not have time to monitor his trades and check the charts every day.

Price Does Not Equate to Value

By buying companies outright, we can enjoy the peace of mind without facing margin calls. Should the market crash, there will only be paper losses and we can buy more of the company, provided the company is still fundamentally sound. Investing doesn’t involve one checking the stock price everyday as the value of the company does not fluctuate every day. For example, Breadtalk may not necessarily have sold 1% less bread than yesterday just because the stock price dipped by 1%.

Foolish Takeaway

Here at Motley Fool, we advocate long-term investing in great companies instead of using leverage to magnify our returns. Using CFDs may lead to an emotional roller-coaster for the uninitiated. Margin calls are the dread of any trader. We prefer sticking to our circle of competence of investing in businesses for the long-term.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.  Motley Fool Singapore contributor Sudhan P doesn’t own shares in any companies mentioned.